For decades, real estate investors have applied tax deferral strategies like the 1031 Exchange to avoid paying capital gains taxes on high-value assets. SDIRAs, qualified opportunity funds, tax-loss harvesting, primary residence exclusions, and 1031 exchanges can all defer capital gains taxes on property. However, these deferral strategies often rely on the type of property and the tax filing status of their owners. Real estate investors commonly use IRS Code Section 103 to exchange like properties, thus transferring and deferring tax payments.
Pending changes to the IRS tax code could impede attempts to defer capital gains taxes through Section 103. The Biden Administration has expressed a desire to curtail like-kind exchanges of high-value properties in coming years. The changes could affect the tax burden on various types of investment property owners. It could impact those who rent out vacation cabins and those who manage multi-unit properties. Follow below to learn more about 1031 exchanges and how proposed legislation could affect the ability of investors to defer real estate taxes by tightening 1031 exchange rules.
What Are Capital Gains?
According to a recent article by Grace Enda and William G. Gale for The Brookings Institute, “a capital gain is the increase in value of an asset over time.” Technically, write Gale and Enda, “a capital gain is a difference between an asset’s current value and its ‘basis,'” with the basis representing a property’s “cost to the owner.” When the value of an asset increases over time, investors must by tax law repay some of that accrued value in the form of capital gains tax. This property tax bill becomes due at the time of sale.
Theoretically, property owners can use proceeds from the sale to pay off any capital gains property taxes based on the accrual of value throughout ownership. Capital gains taxes apply only to realized profits, not to unrealized profits based on assessed value, which is how capital gains taxes differ from annual property taxes. As such, capital gains property taxes are not levied on property currently within an owner’s possession.
Types of Taxes on Capital Gains
There are two types of capital gains taxes imposed by the IRS: short-term and long-term capital gains. In his article “Capital Gains Tax” for Investopedia, Jason Fernando explains that long-term capital gains apply to assets listed for sale after at least one year of ownership. According to Fernando, property sold after at least a year of ownership is subject to capital gains taxes at rates of “0%, 15%, or 20%, depending on the taxpayer’s tax bracket for that year.”
Short-term capital gains tax applies only to property held by the owner for under a year. In these cases, profit made from the sale of a property is “taxed as ordinary income.” Properties held for under a year are usually subject to much higher tax rates than the long-term capital gains tax. Real estate investors often seek ways to defer because capital gains tax can be as much as 20% of a property’s sale price.
How Can One Defer Capital Gains Tax?
There are a few legal methods by which real estate investors can defer capital gains taxes. In his article “How Do I Avoid Capital Gains Tax When Selling a House?“, Certified Financial Planner Matt Frankel outlines five common methods. According to CFP Frankel, property owners can defer capital gains tax post-sale through SDIRAs, qualified opportunity funds, tax-loss harvesting, primary residence exclusion, and 1031 exchanges.
SDIRAs allow future property owners to defer this tax by “owning real estate within a retirement account” (Frankel). Property owned within a self-directed IRA is not subject to capital gains taxes upon sale, even when “you sell for a profit.” Taxes are only due when you finally withdraw from your IRA.
Qualified Opportunity Funds
Qualified opportunity funds are another way by which property owners defer capital gains tax. Opportunity funds encourage real estate investors — usually developers — to invest in economically depressed areas, often designated opportunity zones. To encourage developers to invest in underserved communities, a state or local government might offer tax incentives. These tax incentives might include reduced, deferred, or forgiven taxes on capital gains.
Another method by which real estate investors avoid taxes on capital gains is tax-loss harvesting. For Forbes, John Schmidt and Rebecca Baldridge explain tax-loss harvesting as “when you sell some investments at a loss to offset gains you’ve realized by selling other stocks at a profit”(Can Tax Loss Harvesting Improve Your Investing Returns?).”
What does this mean? You only pay taxes on your net profit or the amount you’ve gained minus the amount you lost, which can reduce your tax bill significantly. In addition to lowering taxes owed, real estate investors often engage in tax-loss harvesting because it “frees up cash so you can buy new assets that may be more likely to generate positive performance.”
Primary Residence Exclusion
Identifying a property as one’s primary residence can lower one’s tax burden. In her article “What Is the Section 121 Exclusion?” , Lea Uradu explains that Internal Revenue Service Section 121 “allows homeowners to exclude up to $250,000 ($500,000 for joint filers) of capital gain from the sale of their primary residence.”
With a primary residence, only capital gains exceeding this amount are reported and subject to CG taxes. While Section 121 is helpful for homeowners and often a life-saver, it rarely helps real estate investors with multiple properties. There are a few exceptions, however. If a property owner chooses to live in their rental property several years before selling, they could limit the CG taxes that come due when the property sells.
In his article “How Do I Avoid Capital Gains Tax When Selling a House?“, Matt Frankel identifies 1031 exchanges as “the most effective, commonly used strategy by real estate investors to avoid capital gains taxes.” For those unfamiliar with the term, 1031 exchanges are also referred to as “like-kind exchanges.” 1031 exchanges allow the owner of an investment property, such as a rental property, to sell their property and “use the proceeds to buy another investment property.”
Until this new property is acquired, taxes on capital gains are deferred. When one wishes to sell this newly purchased property, the owner can “complete another 1031 exchange.” This allowance permits property owners to “use the 1031 exchange strategy to defer capital gains tax indefinitely.”
What Exactly is a 1031 Exchange?
Writing for Investopedia in his article “1031 Exchange Rules: What You Need to Know,” Robert W. Wood explains like-kind exchanges in further depth. Wood notes that though 1031 exchanges allow real estate investors to defer taxes on capital gains, there are several restrictions. For instance, 1031 exchanges apply only to qualifying like-kind exchanges of property or other assets. Typically, a replacement property is of equal or greater value than the original asset. Misunderstanding the properties and situations to which 1031 exchanges apply could legally and financially imperil investors.
While the rules surrounding like-kind exchanges are “surprisingly liberal,” Wood writes that “there are traps for the unwary.” Special 1031 exchange rules apply to rental properties, vacation homes, and depreciable properties.
Recent changes to the Internal Revenue Code have tightened restrictions on applying 1031 exchanges to rental properties, particularly vacation homes. In 2018, the Trump administration altered the legal definition of 1031 exchanges. From then on, 1031 exchanges applied only to real estate. Additional charges are expected in the coming months under the Biden Administration.
Current 1031 Exchange Rules
In his article “1031 Exchange Rules: What You Need to Know” for Investopedia, Robert W. Wood notes that like-kind exchange rules apply to timing, property type, and property value. First, Wood identifies two current 1031 exchange “timing rules.” These include the forty-five-day rule and the one-hundred-eighty rule. According to Wood, the first timing rule relates to the classification of one’s replacement property. After a property sells, proceeds from the sale transfer to a qualified intermediary. The seller of this property cannot take possession of these proceeds until the initial forty-five-day period has expired. Otherwise, one could “spoil the 1031 treatment.”
The seller must also inform the qualified intermediary that they intend to designate a replacement property during this period. The replacement property must be specified to the qualified intermediary during this time. If you are unsure which property you intend to acquire, you can identify up to three properties to your qualified intermediary.
Of course, there is a second timing-related delayed exchange rule. The 180-Day Rule requires a seller to complete the purchase process of their replacement property within one hundred eighty days after the sale of their relinquished property. There may be a gap between the sale price of the first property and the purchase price of the replacement property. If this occurs, the real estate investor must pay CG taxes on this amount. Sometimes, this amount of profit from real estate investing can be offset and exempted from immediate taxation. Investors must keep in mind that 1031 exchange rules vary from state to state.
Like-Kind Exchange Rules for Vacation Homes
1031 exchanges require investors to exchange a relinquished property for a like-kind replacement property. As such, property owners cannot replace personal property with investment property and vice versa, expecting to defer tax on capital gains. Matt Frankel explains in his article “1031 Exchanges: The Basics, Rules, & Requirements“. The Certified Financial Planner explains that in a 1031 exchange, “you can’t sell an investment property, acquire a vacation home for you and your family, and call it a 1031 exchange.” However, property owners can “sell a single-family rental home and acquire a retail building, as long as both assets” are business or investment properties.
There are ways to defer payment of capital gains during a vacation home or rental property sale. Robyn A. Friedman explains in the article “A Treasured Tax Break for the Smart Real-Estate Investor” for The Wall Street Journal. According to Friedman, property owners can convert their vacation home “from personal use to business use by renting it out for at least 14 days a year for two successive years before the sale.” After this two-year period has concluded, the owner can exchange their vacation home and “defer capital-gains taxes as long as they continue to rent for a minimum of 14 days a year for two years after the sale.” However, property owners must remember that only real property is covered. Friedman writes that “personal property is excluded from like-kind exchanges.” Property owners should also remember that rules surrounding tax-deferred in 1031 exchanges are likely to change during the Biden Administration.
How 1031 Exchanges Could Change Under the Biden Administration
Rules surrounding deferred exchange and real estate tax as defined by the Internal Revenue Code could change significantly in the coming months as the Biden Administration weighs their consequences and benefits. According to Will Parker in his article “Biden Proposal Would Close Longtime Real-Estate Tax Loophole” for The Wall Street Journal, Biden’s proposal would “abolish 1031 exchanges on real-estate profits of more than $500,000” for a single person. Any amount over $500K (or $1 million for married couples) could not be deferred and would be subject to annual tax on capital gains.
Parker writes that desire to abolish exchanges of high-value properties has arisen from a flaw in the tax code design. According to Parker, “in theory, capital-gains tax from these deals eventually gets paid.” However, many of today’s real estate investors “buy and sell properties this way until they die, passing the capital gains on to their heirs tax-free at death.”
Sometimes, real estate investors pass capital gains taxes from commercial real estate, like multi unit property for sale.The Biden Administration believes that these loopholes in Section 103 “disproportionately allow the very wealthy to avoid taxation.” In addition to eliminating 1031 exchanges on high-value properties, the new administration plans to change the capital gains tax rate. This administration hopes to “raise the top rate paid on capital gains and dividends to 39.6% from 20%.”
When Would Changes to Section 103 Occur?
As Lynn Mucenski Keck writes in her article “Like-Kind Exchanges To Be Limited Under Biden’s Tax Proposals,” changes to the Internal Revenue Code are difficult to implement. According to Keck, “many practitioners are still grappling with the impact of the TCJA on their tax planning.” For those unfamiliar, the TCJA refers to the Tax Cuts and Jobs Act of 2017. Keck writes that the Biden Administration plans to implement their new changes to Section 103 by the end of 2021.
As such, the new “limited 1031 deferral provision [would apply to] exchanges completed in tax years after December 31, 2021.” Those who have entered into exchanges under today’s tax code would still be able to take full advantage of the 180-day time slot currently allotted. Though adjusting to these changes to Section 103 might be difficult, this buffer should help real estate investors and their financial planners navigate new property for exchange rules.